The decade-long expansion of private credit, against the backdrop of rising credit pressures, has put the focus on the burgeoning challenges in an opaque market. The Credit Conditions Committees of S&P Global Ratings manage our house view on credit developments and each quarter compile a list of top risks globally and regionally (for Asia-Pacific, Emerging Markets, Europe, and North America), to assess the impact of these uncertainties on various borrowers.

In this Credit FAQ, we discuss how these top risks might affect private credit, and whether private credit poses a systemic risk.

What risk factors are associated with private credit?

The risk factors associated with private credit are the same as for mainstream credit, but the emphasis will differ depending on the borrower's stage of life cycle and broader credit conditions cycle.

The risk factors for a borrower are the usual "5Cs" of credit:

• Character--we call it management/governance and financial policy in our corporate ratings methodology (see chart 1);
• Conditions--country and industry risks;
• Capacity--competitive position, diversification/portfolio effect;
• Cash--cash flow, liquidity; and
• Capital--leverage, capital structure.

Character (essentially management competence) always remains key. As for other factors, the emphasis steadily shifts from capital during the borrower's seed stage, to cash, then to capacity and conditions in its mature stage.

Chart 1

Regarding the broader credit conditions cycle, borrowers are facing a tougher financing and economic environment and elevated geopolitical, technological, and ecological risks. Indeed, for the North America region as an example, we identify higher financing costs, a U.S. recession, cost pressures, falling asset values exacerbating commercial real estate losses, and threat of further U.S. bank failures as top macro-credit risks (see chart 2 and "Credit Conditions North America Q4 2023: Shift To Low Gear," published Sept. 26, 2023).

Chart 2

With the vast majority of private credit borrowers tending to be equivalent to speculative grade (those rated 'BB+' or lower), against the backdrop of a difficult stage of credit conditions, our emphasis in credit assessment must be on how macro-credit risks translate into borrower cash flow stress.

How are U.S. private credit borrowers affected by "higher for longer" conditions?

The floating-rate nature of private credit means that unhedged borrowers are sensitive to interest rate increases. For example, focusing on the assets of U.S. business development companies (BDCs), yields on their private credit loans rose about 350 basis points over the past year and averaged 10.7% in the first quarter 2023, in the face of the Fed's monetary tightening (see chart 3). In addition, among the BDCs we rate, there has been a rise in non-accruals and payment-in-kind (PIK) income as a percentage of gross investment income as borrowers' interest coverage declines. If interest rates remain higher for longer, these borrowers could suffer from more severe liquidity strains. For companies whose business model requires significant upfront investment, the need to prioritize liquidity could come at the expense of their long-term growth (see "Rocky Road Ahead For Recurring-Revenue Loans," published June 21, 2023).

Chart 3

In addition, waning demand in light of the weakening economic outlook, combined with more limited ability to pass through higher costs, could squeeze profit margins of these smaller borrowers. For example, health care providers and services, a sector that has a relatively large representation in S&P Global Ratings' credit estimates, has seen many downgrades in the first half of 2023, due partly to continuing labor constraints and inflationary pressures (see "Middle-Market CLO And Private Credit Quarterly: Navigating The Post-Pandemic Economy," published July 24, 2023).

Does private credit pose a systemic risk?

Probably no, possibly yes. The North American private credit market is estimated to be about $700 billion disbursed, with another $280 billion undisbursed (so-called "dry powder") as of first-quarter 2023, while Europe's market is about half the size (according to data from Preqin). The disbursed amounts translate to roughly 4% of U.S. and 1% of European total nonfinancial corporate debt, respectively (data source of total nonfinancial corporate debt: Institute of International Finance). These low percentages support the argument that private credit is a significant--but not substantial--risk to financial systems.

However, systemic risk also arises from concentration and confidence effects. Concentration effect comes about when a small number of players carry substantial, non-transparent risk by volume and underlying credit quality. This was seen during the Global Financial Crisis of 2008-2009 with Lehman Brothers and American Insurance Group (AIG). The fall of such concentrated players triggers a crisis of market confidence given the lack of transparency regarding the quality of their underlying assets (i.e., borrowings).

In the private credit space, the players are institutional investors, fund intermediaries, and borrowers. We perceive there to be considerable information asymmetry between institutional investors and fund intermediaries about borrower quality. Given the less mature private credit market in Europe, this asymmetry could arguably be more pronounced in Europe versus the U.S. Similar to other intermediaries in other financial markets, such as banks and hedge funds, fund intermediaries are able to focus more resources on understanding their private credit borrowers than end institutional investors. Unsurprisingly, fund intermediaries prefer to operate with maximum flexibility and minimal (investor-imposed) constraints.

While banks historically have also extended non-public bilateral loans (i.e., no third-party involvement), a bank has direct access to the borrower and, at least in theory, knows the customer. This is not necessarily the case for institutional investors in private credit. They rely on the expertise and goodwill of the fund intermediaries. Consequently, the ongoing tension between investors seeking more transparency and fund intermediaries striving to shield greater disclosure regarding asset quality and player concentration, supports the counterargument that the private credit sector possibly poses a systemic risk to financial markets.